Interest rates are up, inflation is down – what is going on?

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.

After dragging his feet for months, Stephen Poloz, the Governor of the Bank of Canada, threw in the towel. He raised the policy interest rate to 0.75 per cent from 0.50 per cent on July 12, the first increase in nearly seven years. The probability of another hike in interest rates in October based on recent trading of interest rate derivatives is pegged at 75 per cent.

The shift has prompted some pundits to ask why rates are rising when inflation is still well below the bank's 2-per-cent target. But rising inflation is only one of the factors that may cause an increase in interest rates. Another is elevated economic activity. Yet another is the interaction of demographics and technology.

Let me explain. The nominal interest rate – the reward for making an investment – can be broken down into three components: 1) the real interest rate, that is, the reward for postponing consumption; 2) a premium for expected inflation, that is, the reward for possible loss of purchasing power; and 3) a risk premium – the reward for possible loss of capital. (I will ignore the risk premium in my discussion as it is negligible when we are talking about government securities.)

In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts, the real interest rate falls. The long-term trend of the real interest rate is affected by factors that change only slowly, namely technology and demographics.

In the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails, among other things, on productive capacity and the labour and commodities markets. In the long run, it is taxes, economic efficiency and productivity that impact inflationary expectations.

Economic activity has recently picked up not only in Canada, but around the globe, driving the real interest rate higher. For example, Statistics Canada reported that GDP jumped 0.6 per cent in May vs. expectations of 0.2 per cent, while year-over-year GDP was up 4.6 per cent – the fastest growth since 2000. Meanwhile, the World Bank forecasts global economic growth of 2.7 per cent in 2017 and 2.9 per cent in 2018, up from 2.4 per cent in 2016.

Demographic developments are also pushing the real interest rate trend higher. Baby boomers have started to retire in larger numbers and have stopped saving; in fact, they are in their de-saving (consumption) years, which reduces the supply of investable funds. This happens in the face of increased demand for capital by corporations that need to embed new technologies into their production processes, as well as by governments that need to borrow to fund structural deficits. To clear the demand-supply imbalance, the real interest rate trend is pushed up.

Inflation in the short run is not going up, for a number of reasons beyond the scope of this column, including factors related to technology and corporate concentration that limit price increases and wage growth, but the long-term trend may be more worrisome. We may be reaching a peak in productivity growth as experienced baby boomers retire and are replaced by less experienced workers who will nevertheless be in high demand. These workers will demand higher wages. This means higher inflation down the road.

In summary, there are upward pressures on real interest rates related both to short-run and long-run factors. On the other hand, the news on the inflation front is quiet in the short run but there is a concern for the long term.

How has this played out in the U.S. and Canadian bond markets? And how have nominal and real return bonds responded to these developments? Based on what I've discussed above, the prices of real return bonds (which are inversely related to real interest rates) should have fallen much more sharply than nominal long-term bond prices (which are inversely related to nominal interest rates). Indeed, this is exactly what has transpired.

The iShares Canadian Real Return Bond Index ETF (XRB-TSX) is down more than 8 per cent since July, 2016, while the iShares Core Canadian Universe Bond Index ETF (XBB-TSX) is down only about 5 per cent over the same period. Given the way things are unfolding, the underperformance of real return bonds will continue.